The stock market is within a few percentage points of its all-time high, unemployment is at record low levels, and GDP has never been better. Corporate revenue and earnings are near records. Borrowing rates are low and inflation is low. It’s difficult to find any data that suggests a recession is on the way. Yet everywhere we turn, pundits are bearish. Why do we hear so many economists talking about a big chance of a recession sometime in the next few years?
According to economists, earnings comparisons are tougher, tariffs are terrible, a weak Europe is the start of a global recession, all the benefits of the tax cuts are over, negative interest rates are bad for asset values, among other things. When pressed, though, the most common reason is that the economy has been good for too long and that can’t last much longer.
This seems new. Perfectly capable economists are predicting recession simply on the basis of a recession being “due.” The longevity of the current recovery is simply too long for some people to stomach, believing that the “natural cycle” of recoveries is just 3.2 years, the average of the 1854-2007 time period. So, we are “overdue by 4.5 years,” according to an October 2018 Forbes article. The recent market corrections in the fall of 2018, in May 2019, and again in August 2019, have all unfolded with a healthy dose of concern about near-term earnings, GDP growth, China tariffs, and the policy of the Fed, all of which together have formed a mosaic of imminent recession, which many pundits say will arrive by late 2019, or certainly by 2020 at the latest.
GDP & Inflation’s Role
Two economic metrics that are key to this discussion are real GDP and inflation. In part, it is low real GDP growth compared to past recoveries that creates concerns about the longevity of the current expansion. Inflation estimates are used to make real output estimates from nominal sales reports, which then are used to estimate real GDP. Real GDP growth estimates obviously help drive analysts’ revenue and earnings growth assumptions and help to inform the Fed’s policy decisions. The problem with this is that these estimates are wrong, and economists know it.
The CPI (Consumer Price Index) is the inflation measure used in these estimates. It is created using baskets of goods in dozens of locations around the U.S. The current survey methodology ignores certain substitution behaviors, doesn’t account for discounts at outlet stores, doesn’t account for new products, and quite often ignores quality differences between discontinued products and those that replace them in the baskets. The CPI is known to overstate inflation by as much as 0.4% per year. The PCE (Personal Consumption Expenditures deflator) is a more accurate, lower inflation estimate, but it is not as timely and goes unused. That leads to an understating of real GDP growth, which is of course the remainder after adjusting nominal GDP by the inflation estimate. While that’s a modest error in the short run, it’s a giant error in the long run. Not only is real GDP growth understated, but with inflation overstated, real wage gains are understated. With real GDP growth and real wage gains understated, the current economy seems more tenuous and it makes near term recessions easier for economists to predict.
Another element to the mismeasurement thesis is the mismeasurement of GDP itself. In addition to the problem of measuring general inflation discussed above, there is also the problem of determining whether a price increase is a feature enhancement or inflation. It’s likely that many feature enhancements are being misdiagnosed as inflation. There’s the problem of not measuring the convenience of using OpenTable and the time it saves to do other things. This isn’t captured. In fact, it’s likely that a whole host of new conveniences along with productivity and lifestyle enhancers from Waze to Live Nation to Amazon Fresh are not being captured in GDP growth because the benefits are hard to measure in terms of time saved, not to mention what beneficial activity is created during that extra time.
Finally, traditional causes of recession, the mismatched timing and bad forecasting of inventory and end demand, are increasingly tamed by transparency in the supply chain. In general, the vast benefits of the instantaneous flow of information to everyone or anyone are still working their way through the economy, quite possibly in ways that are difficult to measure with tools originally designed to count units and weigh output. With long-term real GDP growth and living standard gains mis-measured and the full economic benefits of the internet still not fully understood, I believe there is a reasonable case that the economy is not only better than generally believed but also that real wages have risen more than believed for 30 years. If only we were using the PCE instead of the CPI.
So What Will Happen Next?
I will warn the reader that predictions about the economy are best made after the fact! But having said that, based on the metrics, the economy looks pretty good. We see a full employment economy with low interest rates, good access to credit, low energy prices, and a growing population. These are usually good elements for continued economic growth.
It’s always hard to see what the causes of the next recession will be, but now with transparency in the supply chain, one of the typical historical causes of recession has been meaningfully reduced. An energy shock, a cause of some past recessions, seems unlikely as the U.S. is now self-sufficient in energy. A bubble on Wall Street is always possible, but valuations are not excessive relative to low interest rates and inflation. Tariffs and trade wars are always a risk. One thing that’s new is that because it’s difficult to increase prices or hire more people in this low inflation, low unemployment environment, businesses are intensely focused on improving productivity as the path to higher margins, profits and ultimately, higher stock valuations. Higher productivity then raises real GDP growth!
So, I remain bullish on the U.S. economy, believe real GDP growth is higher than is generally believed, and believe the U.S. market will continue to deliver attractive returns. And please don’t try to time a recession! When it finally arrives, most likely unexpectedly, remember that it will likely be short and that stocks are likely to recover in the year after. Long term equity returns are almost always best delivered by holding equities for the long term, and if GDP growth is revised upward, all the better!
About the Author:
Kevin Silverman is the Chief Investment Officer and Portfolio Manager of Sterling Partners Equity Advisors. Before joining Sterling, Kevin managed portfolios and strategies for Falcon Capital Management and Dearborn Partners. He received a MS in Finance and a BBA in Finance from University of Wisconsin-Madison and is a CFA® charterholder and committee member in the CFA Society of Chicago.
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